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Flowers Foods (FLO)

Flowers Foods (FLO) was founded in 1919 and has grown to become the second-largest producer of packaged bakery foods in the country with over 40 operating bakeries. The company primarily sells breads, buns, rolls, tortillas, and snack cakes, and some of its key brands include Nature’s Own (the number one bread in the U.S.), Tastykake, Wonder Bread, Whitewheat, and Dave’s Killer Bread. Flowers Foods also bakes store-branded generic products.
Source: Flower Foods
The vast majority of the company's sales are in fresh breads and rolls, with snack foods and frozens products making up the rest of revenue.
Source: Flowers Foods
Approximately 85% of Flowers’ sales last year were Direct Store Delivery, in which fresh products are delivered directly to customers (supermarkets, mass merchandisers, restaurants, etc.) via a network of more than 5,600 independent distributors.  

The remaining 15% of revenue is derived from Warehouse Distribution, which includes fresh and frozen products (snack cakes, frozen breads and rolls, etc.)  that are shipped to customers’ warehouses nationwide. This segment mainly serves  retail (43% of sales), and foodservice customers (39% of revenue). 

Business Analysis

Flowers Foods operates in the consumer staples sector, primarily focusing on fresh packaged breads, which 98.6% of U.S. households buy, according to the company. Bread is also the number one grocery category in weekly true profits, and the U.S. bread market, both retail grocery and food service, is a $36 billion industry that grew at 1.7% last year.

The products Flowers sells are going to remain relevant and in demand by practically every household in the country for many years to come. Industries with a slow pace of change tend to appeal to conservative dividend investors, and Flowers’ business certainly checks that box.

While there are seemingly few barriers to entry in the industry, Flowers derives several advantages from its longevity (the company is nearly 100 years old).

Flowers has built up a large handful of brands with strong recognition over several decades. For example, the company’s Nature’s Own brand was introduced in 1977 and has built a strong reputation by never using any artificial flavors, colors, or preservatives in its baked foods since inception. Nature’s Own is now a $1.1 billion brand that is number one in the U.S. in sales of both white and wheat loaves.

With over $30 million spent on advertising each of the past two years, Flowers defends its market share in part due to favorable brand recognition with consumers. Smaller rivals don’t have the budget to build up competitive brand awareness.

Retailers also have strong relationships with Flowers and only have so much shelf space for the categories that the company participates in. As long as Flowers’ baked foods continue selling, there is little incentive for retail customers to give shelf space to unproven new entrants in the market, especially given the relatively low level of differentiation in a category such as bread.

Since product differentiation is generally perceived to be lower, maintaining an efficient production and distribution system is particularly important. Over the past century, Flowers Foods has mostly gained scale by acquiring regional bakeries and baked goods brands. 

Today the company is America's second largest producer of packaged bakery goods with total market share of approximately 20% and annual revenue near $4 billion, which provides several cost advantages.
Source: Flowers Foods
The company enjoys economies of scale in purchasing its raw materials, mass producing its bakery foods, investing in efficient production facilities, and distributing its products.

Importantly, Flowers’ size has also helped it strategically locate production facilities near key markets, resulting in fresher products at the time of delivery and logistics cost savings. Many of its fresh products require frequent deliveries to keep store shelves well-stocked, which rewards suppliers with the densest and most convenient distribution networks.

Despite the company’s strong brands and economies of scale, its market is mature and has a low organic growth profile. The baked goods market is also highly fragmented with nearly 45% of it composed of store brands and independent bakeries. As a result, Flowers has been consolidating the market for many years.

In fact, since its 1968 IPO, Flowers Foods has bought over 100 small regional companies, brands, and bakeries, largely in areas where it has not previously had much of a presence. That includes 16 deals since 2003 that have helped more than doubled sales from $1.9 billion per year to $3.9 billion.

The largest player in the industry, Grupo Bimbo, has also helped consolidate the market. In 2011, it bought Sara Lee’s fresh bakery segment in North America.  The three biggest players in the industry now account for over half of the market, which has encouraged more rational pricing.

Acquisitions have also helped Flowers enter faster-growing segments of the market to stay on top of changing consumer trends. The company now claims to have the leading position in the organic segment of the $2 billion specialty / premium loaf category through its acquisitions of Dave’s Killer Bread and Alpine Valley Breads.  

Looking ahead, the company's core growth plan consists of four primary components:

  • Acquisitions
  • Opening up new markets
  • New product launches
  • Economies of scale/efficiency improvements

The first is a disciplined approach to acquisitions, which isn't surprising given the company's history and the market's fragmentation. Many of these acquisitions are increasingly driven by changing consumer tastes, such as growing demand for organic and natural products. 

For example, in September 2015 the company purchased Dave's Killer Bread, the nation’s best-selling organic bread brand. This purchase also provided the Direct Store Delivery segment access to the Pacific Northwest market.

The very next month Flowers bought Alpine Valley Bread, a family-owned producer of certified organic and all natural breads in the U.S. This not only further boosted Flowers' market share in organic breads, but it also increased the company's overall production capacity in this growing industry segment.

In addition to growth through acquisition, Flowers has proven itself to be an industry leader when it comes to organic growth through new product offerings. For instance, with about $1 billion in annual sales, Nature's Own (introduced in 1977) is America's number one bread brand, and has enjoyed 8.3% average sales growth since 2000. 

In 2016, the company introduced a sub brand called Nature’s Own Life. These are natural breads with extra protein, grains, and fiber. They are marketed to increasingly health-conscious consumers interested in reducing calories, sugar, and their glycemic index (such as diabetics).

Management also notes that nearly 28% of retail fresh packaged bread category sales are in the dinner roll and breakfast segments. Flowers' share in those segments is only in the low single-digits. With new product launches under Nature's Own and Dave's Killer Bread, the company expects to continue expanding in these underdeveloped segments. 

Market expansion is the company's third sales growth focus. Flowers Foods began as a regional baked goods company, and most of its top brands retain a regional distribution network.
Source: Flowers Foods 10-K
Over time, the company has focused on building out an increasingly nationwide network of bakeries, distributors, and a more comprehensive supply chain, allowing it to sell more of its products across the country. In 2004, for example, the company's products were sold in about 35% of the country, but today Flowers' baked goods reach 85% of the U.S. population. 

Finally, Flowers hopes to achieve stronger earnings growth over time by increasing its economies of scale and efficiencies. In 2016, Flowers announced a company-wide review called "Project Centennial". This is a five-year restructuring plan to be completed by 2021. The company's goals are to refocus on core brands, boost targeted marketing, optimize the supply chain, lower input costs, and increase automation of bakeries.

Flowers Foods has invested more than $450 million into upgrading its factories and logistics chain over the last five years, demonstrating its commitment to automation. That spending includes an advanced automated shipping system that is now in 87% of it bakeries. 

The company believes that in 2018 alone it will be able to cut annual costs by $70 million to $80 million (compared to 2016 levels). Meanwhile, an improved supply chain is expected to lower input costs by $45 million per year.

The ultimate goal is for the company to achieve long-term EBITDA margins of 12% to 14%, compared to 11.7% in 2015. This higher profitability, combined with 2% to 4% long-term organic sales growth, acquisitions, and share buybacks, should allow for 7% to 9% EPS growth over the long term.

If successful, the company should have no problem continuing to deliver consistent and healthy dividend growth. For example, Flowers Foods has raised its dividend for 15 straight years. With a payout ratio that is currently sustainable given the firm's stable and cash-rich business model, if management can hit its targets, then the company should be capable of mid to high single-digit annual dividend growth over the long term.

With that said, Flowers Foods has several challenges it faces that could cause it to miss management's optimistic projections.

Key Risks

At first glance, Flower Foods' long-term growth guidance is indeed promising. However, keep in mind that guidance has been coming down over time.

  • 2016 guidance: long-term organic growth 3% to 5%, EPS growth 10+%
  • 2017 guidance: organic growth 3% to 4%, EPS growth 8% to 10%
  • 2018 guidance: organic growth 2% to 4%, EPS growth 7% to 9%

Flowers' moderately declining growth outlook is due to several major challenges facing the company. First, changing consumer tastes might mean that brand pricing power in general is decreasing. 

This might be why, despite gaining market share in what was a relatively strong growth year for the bread market, the company's adjusted sales only managed an increase of 0.4% in 2017. Adjusted EPS, which excludes one-time events like tax reform, also slipped around 2% and remains roughly flat with 2013's results. 

Part of challenge Flowers Foods faces is that its sales are relatively concentrated. For example, its top 10 customers represent 48.5% of sales, including Walmart (WMT) which accounts for 20%.

Walmart is famous for "everyday low prices", which causes it to squeeze suppliers like Flowers. The world's largest retailer has also been increasingly focused on its own private label (store brand) products sold under the Great Value name. Walmart actually makes larger profits from its own private label goods than it does by selling branded goods such as Wonder Bread.

This means that when it comes to pricing power with large customers like Walmart, Flowers Foods is likely in a relatively weak negotiating position. In fact, the trouble with retail in general is that even strong cost cutting efforts can result in margins that go nowhere.

For instance, the company's operating margin has basically remained the same for more than a decade. That's despite enormous investments into automation and improved bakeries. In highly competitive, slow growing industries such as this, cost savings often need to be passed onto consumers.

More importantly, in a mature category such as bread, there is only so much market share available for the taking. While the company’s sales have compounded at an 8% annualized rate over the past decade, future growth could be more challenging to come by.

If acquisitive growth becomes too expensive or there are no longer enough needle-moving deals with independent / regional bakeries, Flowers’ growth rate will slow down (Flowers’ organic sales growth was just 0.4% in 2017). The company might also feel pressure to enter adjacent markets to continue expanding, which creates opportunities and risks.

Evolving consumer tastes could also impact the company’s results over time. Consumers are increasingly moving away from gluten and desiring fresh, healthy foods over packaged items with questionable ingredients.

Fortunately, bread seems likely to remain a massive category, and investors don't seem to be expecting much organic growth in the industry anyway, reducing the risk of expectations being missed.

Closing Thoughts on Flowers Foods

Flowers Foods may not be a household name, but many of its brands are. Over the past 100 years, the company has proven itself highly adaptable and capable of top and bottom line expansion through an acquisition-led growth strategy.

While the company faces potential challenges with its Project Centennial ambitions, Flowers' core business model remains highly recession resistant, and its free cash flow is usually very stable. 

The business should be capable of delivering safe and steadily growing dividends over the years ahead, even as many constituents in the consumer staples sector work to adapt their business models to a fresher, healthier world. 

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